Problem 1) Transfer Pricing of Multination Companies Argone Division of Californ

Question

Problem 1) Transfer Pricing of Multination Companies Argone Division of California Instruments is located in the United States. Its effective income tax rate is 30%. Another division of California Instruments, calcia, is located in Canada, where the income tax rate is 42% Calcia manufactures, among other things, an intermediate product for Argone called IP2007. Calcia operates at capacity and makes 8,000 units of IP2007 for Argone each period, at a variable cost of $60/unit. Assume that there are no outside customers for IP200Z. Because the IP2007 must be shipped from Canada to the United States, it costs Calcia an additional $4/unit to ship the product to Argone. There are no direct fixed costs for IP2007. Calcia also manufactures other products. A product similar to IP2007 that Argone could use as a substitute is available in the United States for $75/unit. Argone sells the final product in the external at $120/unit. Required) What is the minimum and maximum transfer price that would be acceptable to Argone and Calcia for IP2007, and why? 1. What transfer price would maximize after tax income for California Instruments as a whole? (Show your computation). Would Calcia and Argone want to be evaluated on operating income (before tax) using this transfer price? 2. 3. Suppose California Instruments uses the transfer price from Requirement 2, and each division is evaluated on its own after-tax division operating income. Now, suppose Calcia has an opportunity to sell 8,000 units of IP2007 to an outside customer for $68 each Calcia will not incur shipping costs because the customer is nearby and offers to pay for shipping. Assume that if Calcia accepts the special order, Argone will have to buy 8,000 units of the substitute product in the United States at $75 per unit. a) Will accepting the special order maximize after-tax income for California Instruments as a whole? b) Will Argone want Calcia to accept this special order? Why or why not? c) Will Calcia want to accept this special order? Explain.

Explanation / Answer

1)The minimum transfer price for Calcia = $64(to cover the variable cost/unit($60) and shipping ($4/unit) costs, because Calcia would want, at a minimum, zero contribution margin. The opportunity cost is $0 because there are no external customers for IP-2007. The maximum transfer price for Argone = $75 , market price that Argone would need to pay to acquire aproduct similar to IP-2007 from the external market in the U.S.

2)To maximize after tax inome you need to minimizr your income tax expense .To minimize income taxes, Gemini should use a transfer price of $64. Canada has a higher tax rate so goods coming from Canada should have the lowest transfer price.

$64

you can see your profits are maximized when you set trasfer price as low as possible from calcia

Calcia would not like a transfer price of $64 because it would report no operating income before tax from the transfer. Argonewould like a transfer price of $64 because it is lower than the outside market price of $75 because it has high operating income before tax

3a)calcia's after tax income on each unit from accepting special order is:

Now assuming that argone has selling price of $120 and it purchases IP2007 subsitute from outside its after tax income when calcia accepts the special order would be:

California instruments net income as a whole ,when calcia accepts the order is $4.64+$31.50=$36.14

As we saw in part 2 if calcia transfers to argone at $64 california instrument's net income as a whole was=$39.20

therfore ,accepting the special order will not maximize the after-tax operating income

3b)Argone would not want calcia to accept the special order as it is more costly to buy substitute from the market than from calcia

3c)Calcia would like to accept the special order as its net operating income after tax pe unit increases by $4.64 y accepting the special offer rather than transferring IP-2007 to argone at $64 and earning $0 operating income

3d)California Insteument would like to set transfer price to $72 per unit.this will result in both divisionss to take action in thier best interest and that is also benefical to calfornia instruments as whole

the opportunity cost of transfering IP-2007 internally is $8 ($68-$60) per unit for the first 8,000 units and $0 thereafter.

the general rule is:Minimum transfer price=Incremental cost per unit incurred upto point of transfer+opportunity cost

so minimum transfer price:

california instrument should use theses minimum transfer price as they as tax efficient

At transfer price of $72 per unit for first 8000 units , calcia is indifferent between accepting the special order or transferring internally. calcia earns $8 ($68-$60) if accepts special order . it also earns $8 if it transfer IP-2007 to Argone ($72-$64)

Argone will like to buy IP-2007 from calcia because transfer price of $72 is lower than purchasing the substitue for $75 from outside market.

$72

Calfornia Instrument's net income=$4.64+$33.60=$38.24

This net income is greater than the $36.14 net income calfornia instruments would have earned had calcia accepted the special order

Calcia Argone Transfer price / Sales Price $64 $120 Less:costs Variable Costs $60 shipping costs $4 Transfer price form calcia

$64

Operating profit before tax $0 $56 Tax rate 42% 30% Less:Tax expense $0 $16.80 Income After Tax $0 $39.20

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